VioletaStoimenova
Introduction
Information Services Group (NASDAQ:III) posted a softer first quarter for what I believe represents more transient macro issues. In other words, as noted last time I still think III is positioned to grow from various initiatives and from the shifting mix to recurring revenue, all of which should be further boosted by operating leverage. With their share price down low-single-digit percent from the Q1 earnings release, I think today’s price offers attractive forward returns assuming the aforementioned assumption is correct.
Sales: Pressures Continuing
III posted sales of $64M in 1Q24, ~$14M or 18% lower than the $78.5M posted in 1Q23 (year-over-year), and ~$2M or ~3% lower than the $66M posted in 4Q23 (sequentially). By region, sales were lower across the board: Americas was down 18% year-over-year, Europe was down 23%, and APAC was down 20%. Sequentially though, the Americas was up marginally, while Europe was down ~11%, and APAC was down ~5%. By product type, recurring revenue was ~$30M in 4Q23 (45% of sales) and ~$30M in 1Q24 (“about half” of sales), implying that non-recurring sales were ~$36M in 4Q23 declining to $34M in 1Q24. So specifically, it was their non-recurring sales that declined sequentially.
When looking at this sequential trend, per comments on the Q4 call, pricing has been an immaterially changing variable, so no impact there. They acquired Ventana Research in October 2023 for $1M, but clearly, that’s a practically immaterial acquisition revenue-wise – i.e., they may have only added ~$2M in annual sales, or ~$500K quarterly. Sequentially speaking, however, since they were acquired on October 31, they contributed 2 months worth of revenue in Q4, thus implying that the benefit in Q1 was relatively immaterial (an extra month’s worth).
I can’t fully tell if there was any material seasonality impact, but my suspicion is that even if we adjust for seasonality, sales still worsened sequentially. Seasonality is somewhat mixed in Q1 as, like Distribution Solutions Group (DSGR), Q4 includes fewer working (selling) days hence historically being a smaller quarter for them. But on the other hand, their non-recurring (Sourcing) revenue is H2 weighted and thus, a sequential step down is normal. Indeed, they’ve noted Q1 being a normally lighter quarter, or perhaps their “lightest”. Historically, 4Q18 to 1Q19 trended lower compared to 4Q17 to 1Q18 which trended higher, but the former period seemingly included some material FX and macro headwinds (Brexit) that impacted natural seasonality. But if we look at this on a year-over-year basis, total sales were down 18% in Q1 compared to being down 11% in Q3. So, my sense is that the step down in sales sequentially was a little more than seasonality could explain.
This would be consistent with their take too, noting how “broader market for technology services remained soft in Q1” as “clients are taking longer to commit to new investments as they weigh economic conditions and work through how to deploy AI for their businesses.” However, I haven’t really gotten that sense when looking at broader data. III actually hosts industry calls and the data they provide was that total global ACV – i.e., the total dollars of outsourced contracts – declined year-over-year in Q4, but then has turned positive in Q1 2024, the “third straight quarter of sequential increases”. Looking at outsourcing vendors, Accenture’s (ACN) managed services sales were 3% higher in Q2, compared to 6% in Q1. Globant (GLOB) posted 11% organic growth in Q4, which grew to 13% in Q1 and exceeded their guidance. And then CTSH posted a 2.4% constant-currency decline in Q4, which improved to ~1% in Q1. So, the overall spending environment seems to be flat-to-up compared to the end of 2023.
On the other hand, we have been coming off of a macro-affected period – i.e., consolidated sales are 18% lower than the first quarter of 2023 – so it’s conceivable some of those behaviors have lingered. And secondly, there’s certainly some merit behind timing impacts – III is servicing big clients with big contracts, so a push out of any one or two can have a sizable revenue impact. And to this end, they noted that they had “two major transactions that were expected to close and begin delivering during the first quarter that were delayed.” For context, III has a total of ~900 clients, and per their public case studies, one client can spend north of $5M. While that certainly reflects a larger client of theirs and not the average, the point here is that a client merely deciding to go with products X instead of X and Y can be $500K in revenue, or close to 100 bps. In other words, sales can be partly lumpy and random.
So, nothing in here screams that they lost market share, which would be consistent with my prior conclusion about III. Zooming out, I don’t really think there’s enough contradictory data to strongly disconfirm what I concluded last time. As I previously wrote, what I think is happening for their legacy sourcing business is that they’re losing customers for value proposition reasons. Once a client gets used to going through the outsourcing process, this obviates their need for third-party assistance, thus reducing III’s demand. Indeed, if we look at sales trends pre-COVID, we can see that III’s top-line was about flat before declining in 2018 and 2019, a period when they really only had their core Sourcing business (although recurring revenue was coming onto the scene in 2018 and 2019).
The presently interesting angle about this setup is that they haven’t benefited in earnest from their new product release. I talked about this in my last write up, but III introduced “ISG Tango” which should allow them to address an untapped pocket – the middle market – of the sourcing market they previously haven’t. It was introduced 2 months ago, so they’ve really just been introducing the product to customers thus far, but they’re apparently running $2.6B of contract value through it already (versus the roughly $200B total contract value they handle). Feedback has (naturally) been positive, but this is what I’d expect – the value has always been there; it’s just been about finding a more cost-effective product to reach middle-market customers.
Their recurring revenue business – which includes (primarily) sales from GovernX, Benchmarking, IPL, Automation, and multi-year MSP contracts – was flat sequentially, which isn’t all that concerning given the general market spending trends we’ve seen, and unlike Sourcing, it’s not a step backwards, but it’s nonetheless a slowdown. For context, while recurring revenues grew 16% in FY23, for 4Q23, they were down to being flat year-over-year with 4Q22, and here in Q1, they were again flat with the prior year. And all of this follows double-digit sales growth in 2021 and 2022.
Here again though, there’s nothing in the results that materially changes my opinion on the future of their sales here. It’s evident that they have a robust value proposition as illustrated by their customer retention rates being in the high-90% range, which partly explains their strong growth over the past few years. To argue this won’t continue – i.e., that today’s minimal growth does not reflect macro pressures – would suggest that they’re either losing market share or that they’ve run out of new customers to target, but those are both very unlikely.
To the former, we don’t have a great set of peers to reference against, but at least for their Research offering – IPL and Benchmark – we can reference Forrester (FORR), who posted a sales decline of nearly 12% in Q1 (although exaggerated by internal initiatives), and Gartner (IT) who posted sales growth of 4.6%. Gartner, then, seems to be doing a little better on a year-over-year basis than III, but from a base rate perspective, it’s unlikely this reflects share loss. For one, III’s Research business has clearly grown over the past 3 years – i.e., double-digits per annum – which is comparable with Gartner’s growth during this period. And from what I can tell, there’s been no discernible change in the value propositions across either company here. Actually, with the acquisition of Ventana, this incrementally augments III’s research offering by giving them more exposure on the vendor software side.
All in all, their guidance largely supports my hypothesis here. They’re expecting ~$66M in sales in Q2, up $2M or ~3% from Q1, although some of this is just natural seasonality in terms of customer decision-making timing. Plus, like they noted on the call, there were two bigger contracts that should’ve been pushed into Q2. So, the sequential guide doesn’t necessarily scream that we’re getting back into material growth mode. However, it does largely reflect stabilization after being impacted by the macro throughout 2023, and the qualitative data they provide supports this too – per the call, they noted:
“Now the good news for the market and ISG — based on our market analysis, client discussions and our pipeline development, the market seems to have bottomed out in the first quarter and the worst appears to be behind us. We are seeing spending coming back slowly and expect further acceleration over the course of the year, macro conditions permitting. Market interest in exploring cost efficiencies through managed services remains at high levels. Additionally, we are now seeing a rise in sourcing activity, and this suggests clients are beginning to balance the desire for cost savings with the need to remain competitive and tech forward.”
All in all, nothing really changes my model from last time – I expect their legacy Sourcing business to decline marginally per annum, ISG Tango to add additional sales from today, and for their recurring revenue to grow. Q1 sales more or less translate into something like $256M in annual sales assuming a 25% weighting (to be conservative – it’s generally less). The rest of 2024 may amount to de minimis growth, but I still think something like 4% growth post-2024 – i.e., post-macro normalization – is achievable, implying that by 2026, they’d be posting ~$277M in sales, and ~$288M by 2027. (This is a change from my prior model, which assumed growth in 2024. Thus, I’m pushing my sales estimate out by 1 year to 2027.)
Margins: Positioned to Grow
Margins materially underperformed their Q4 guidance – versus the 9.8% EBITDA margins they were guiding, gross/EBITDA margins for Q1 came in at 36%/6.8% versus 37.3%/14% in 1Q23, and versus ~38%/~9% in 4Q23. The prior guidance, however, was predicted on $66M in sales, so there is some adjustment that needs to be made for that.
In any event, the decline in margin had more to do with their gross margins as evident by the 38%-to-36% sequential decline. Or in other words, while sales were down ~$2M, “Direct costs and expenses for advisors” increased by ~$300K. First, all else equal, the addition of an extra month’s worth of Ventana’s cost profile alone may have accounted for this dollar delta – they don’t precisely disaggregate it, but that sounds reasonable to me.
However, that doesn’t really explain the decline in margins even if Ventana was margin dilutive just considering how relatively small the sequential impact from Ventana was. One hypothesis is merely that their COGS are largely fixed and the decline in sales couldn’t be matched by a decline in costs, thus resulting in deleverage. I tend to think this could have some merit considering their comments in Q4 about “retaining the key talent we need when demand begins to accelerate this year.” However, they reported 70% consultant utilization in Q1, up from 65% in Q4, which essentially disconfirms that hypothesis.
The improvement in consultant utilization implicitly, since sales are lower, resulted from a reduction headcount. They note on the call how total headcount was up 43 people to 1,561 from Q4, but concurrently point out how this reflects Ventana and a client-specific resource allocation – excluding this and total headcount would’ve been flat. Specifically, then, their consultant headcount must’ve been down while being offset by headcount growth elsewhere. But either way, we can see that the gross margin decline wasn’t really a deleverage thing.
On the other hand, what confuses me is that I don’t think it was driven by price degradation either. We referenced this earlier, but they nor the data suggest there’s any material – or any – pricing declines happening, which I noted with respect to their Q4 results too. Essentially, management’s argument in Q4 is that the sales softness had more to do with the qualitative nature of the projects – wanting more time to study the landscape and the potential impacts – than being dismissive for price-reasons. So, there hasn’t been any material shift on this front to explain margin trends.
So, admittedly, I’m struggling to explain what exactly happened at the gross margin level, and no one on the call cared to address it, oddly. Perhaps it’s just randomness in terms of expense timing that won’t recur. Or perhaps there are some seasonal trends here that I’m missing.
At the operating level, with sales down a few million dollars sequentially, this is obviously a net negative when it comes to operating (fixed cost) leverage. Minus some back-end IT infrastructure expenses, my sense is that the vast majority of their cost profile is payroll/compensation between both “direct selling expenses” – i.e., COGS – and their SG&A. As such, it then becomes clear just how meaningful a reduction in sales can be margin-wise as this results in less labor utilization.
However, we can see that as a percentage of sales, the margin decline resulted from lower gross margin and not operating cost deleverage. Indeed, adjusted costs (which exclude D&A and all of their adjusted EBITDA add-backs) declined from $19.4M to $18.8M, suggesting they’ve taken out some costs. This wouldn’t be an unreasonable inference considering management’s headcount data from the call and, as I noted previously, they started reducing headcount starting mid-2023. And this also so considering that they expensed $3M in severance in the quarter (compared to $4.8M in Q4), so these reductions partly offset some of the natural sales-driven deleverage.
Versus Q4, there was another mix shift tailwind as more of their revenues were derived from recurring revenue sales and less from non-recurring revenues. Margins for their recurring revenue business are – as expected – higher than their non-recurring sales, so of course, as they grow this piece of the revenue pie, margins will naturally benefit.
So, all that said, while I struggle identifying what caused the sequential margin decline, they’re suggesting that it’s not reflective of the go-forward trend. That is, they’re guiding for $7.5M in Q2 EBITDA, which on $66M in sales, would amount to a margin of ~11.4%, up materially from Q1 here – ~$3M in EBITDA growth on ~$2M in sales growth – although still down from the 13.3% posted in 2Q23. Indeed, what should be the case is that as sales grow, they capture incremental operating leverage – i.e., increased consultant utilization – and furthermore, better margins from the mix shift to recurring, so this is a good sign.
If, then, they grow sales to $288M in FY27 sales, that’s $72M quarterly (~$6M higher than today). From one angle then, assuming 13% margins on $66M in sales are normalized, 30% incremental margins would result in ~$1.8M in incremental EBITDA per quarter, or $7.2M annually. I.e., Annual EBITDA would grow from ~$34M today to $41.2M on $288M in sales, or a margin of ~14.3%. That’s not unreasonable. For one, they ~15% margins on $74M in quarterly sales in 2022. And then for two, they’re guiding for $150M in recurring revenue sales by FY25 and 17% EBITDA margins driven by “Phase 2 of ISG Next” – i.e., more efficient consultant delivery. So, sticking with 15% like last time, that gets FY27 sales/EBITDA of ~$288M/~$41.2M.
Valuation: Remains Compelling
There’s nothing new on the capital allocation front – in Q1, they “paid dividends of $2.4 million, repurchased $2.5 million of shares and paid down debt of $5 million,” so an equal distribution. I still think that M&A is a relatively low risk considering that (1) the deals they’re doing are small tuck-ins, so there’s not much capital at risk, and (2) they’re seemingly valuation sensitive. Over time, I expect most of their free-cash-flow to go to shareholders via the aforementioned outlets.
At today’s price of $3.2/share with 48.665M basic S/O, that’s a $158M market cap. Net of ~$14M of cash and ~$74M of total debt, that’s an EV of ~$218M.
My model from my earlier conclusion would add up to sales/EBITDA of ~$288M/~$41.2M for FY27 (again, extended a year from my last model). Minus D&A at 2% of sales ($5.8M), SBC at 3% of sales ($8.6M), $6M of interest expense, and a 32% marginal tax rate (which will decline as sales shift to recurring revenue which has a higher U.S. customer base), this gets me to a net income figure of ~$14.1M in FY27. Add back D&A and back out ~$3.5M of normalized capex and I get $16.4M in FCF.
Even a modest multiple is going to imply material upside potential, so it’s not really a question of what III could be worth, but whether those economics are achievable. Assuming a conservative ~15x FCF multiple, that implies a market cap of $246M at the end of 2027. Adding in cash flow of ~$50M generated in the interim, and that gets me to an implied market cap of ~$320M, or ~$6.1/share, well above today’s $3.2/share.
So, if today’s price makes sense, one basically has to assume that they don’t grow sales from here, which essentially implies that something actually has to change from today. That is, per today’s data, if we simply remove some of the macro noise, they have a recurring revenue business that’s growing with further growth likely to come from ISG Tango. I’m assuming that the low-teens guided margin for Q2 is more normalized, but I think this is a fair assumption, particularly given the inherent operating leverage.
Of course, there are some risks here that could impact them. M&A comes to mind as we just discussed, but this is a fairly small risk in my opinion. A declining Sourcing business weakens offerings within their recurring revenue portfolio, but the introduction of ISG Tango essentially defers this. And then three, there’s some risk around the macro and that potentially worsening, but the broader data seems to support the hypothesis that conditions are stabilizing.
Conclusion
Putting it all together, I still believe that III represents a relatively attractive risk/reward at today’s price in the low-$3/share range. Like I just noted, there are some risks with the story and this is a business undergoing a good amount of change, so it might not be a smooth ride, but structurally speaking, it’s conceivable to me that they’re a business bigger 3 years from now by simply looking at the bigger variables at play.
